Circle of Friends

by Charles Gasparino

  Steinberg’s arrest came in classic Perfect Hedge fashion—in the early morning hours, and with FBI agents equipped with bulletproof vests and guns at their side providing their targets with a grim introduction to what it’s like going up against the federal government’s vast white-collar crime fighting apparatus. It is meant as a warning to both Steinberg and anyone else targeted in the inquiry that fighting the government comes at a price, legal experts say.

  One thing seems clear: Since 2007, civil and criminal authorities have spared almost no expense trying to snare the man who on paper at least is considered among the world’s greatest investors. Steve Cohen and his advisers say SAC’s investment record—nearly 30 percent annual returns since the fund began in 1992—is the result of research and skill, flowing from the man at the top of the firm through the best traders, investors, and analysts in the business. Federal investigators, however, appear convinced that same success is the result of having—at least at times—an illegal edge over public investors through the use of inside information gleaned from various confidential sources.

  So convinced are they, in fact, that at one point, the FBI even received court approval to wiretap Cohen’s home telephone—one of the first times in law enforcement history that wiretaps would be used in a white-collar case. While the wiretaps were unhelpful in making a case against Cohen, the scrutiny continues. SAC recently paid more than $600 million to settle a civil inquiry by the Securities and Exchange Commission without admitting or denying wrongdoing. The inquiry involved a former portfolio manager who allegedly traded on inside information regarding a pair of drug stocks. Just before Christmas of 2012, that former portfolio manager, Mathew Martoma, was himself indicted for allegedly trading on inside information. A key aspect of the indictment was a section where Martoma holds a 20-minute telephone call with Cohen—and then SAC abruptly sells hundreds of millions of dollars of the drug stocks in question.

  What exactly was said during that telephone conversation is unclear; what isn’t is the fact that the Justice Department has told Martoma that it is willing to trade leniency for his cooperation against Cohen.

  Martoma—as he awaits trial—has taken the Steinberg route, both by declaring his innocence of the charges and at least for now refusing to characterize that what he told his old boss was anything but aboveboard. That might change as well since Martoma is facing a similarly long jail term if he doesn’t cooperate. With that, SAC remains on edge; the fund has produced some of the biggest returns in the investing world for more than two decades, but investor cash is starting to drain out amid the scrutiny. Cohen, for his part, has declined repeated attempts to be interviewed for this book. Through a spokesman, he has maintained his innocence, saying he has acted properly at all times. But prosecutors aren’t impressed. The indictment of Martoma went to great lengths to point to Cohen as the possible recipient of one of the profitable insider tips that are central to the case. The indictment stopped short of saying Cohen knew the tip was dirty, or mentioning Cohen specifically by name (it referred to him as the hedge fund “owner” and “portfolio-manager A”).

  But the message was delivered loud and clear.

  White-collar law enforcement authorities will tell you that one of the reasons—and maybe the biggest reason—that they have approached insider trading with such zeal, particularly since the start of Perfect Hedge in 2007, is to make the investing world safe for the average investor.

  They will talk nonstop about the virtues of ridding the investing world of insider trading. To hear it from these folks, getting information that’s not available to the public through a high-level connection or by paying for it—the basic definition of insider trading—perverts the very essence of what a market is all about: a level playing field where everyone, regardless of wealth or status, has access to the same information from which they can make educated choices about buying and selling stocks.

  And they will tell you that the fundamental purpose of the laws governing the markets is to democratize those markets. They will point out, and rightly so, that the Securities and Exchange Commission, the main law enforcement agency in charge of monitoring Wall Street behavior, was created in the aftermath of the stock market crash of 1929, precisely to level the playing field between the sophisticated investor who buys stocks for a living and has the means to buy information not available to the average person, and that very same average Joe, who has a day job and is investing for retirement.

  The two main bodies of law from which most of the rules of investing are derived, the Securities Acts of 1933 and 1934, demand disclosure of information broadly and equally, meaning that the very act of trading on a piece of information that is obtained before it is formally disclosed to the general public is anathema to the notion of fairness that permeates these statutes.

  They will also tell you that when someone trades on an inside tip that isn’t available to the public, that trade is being made often on stolen or “misappropriated” information, and there are plenty of laws against theft.

  These are strong and convincing arguments, which is why insider trading rouses so much anger among average people. The notion that someone has an unfair advantage over someone else seems un-American; after all, our nation is built on fundamental ideas of equality and fairness (indeed, “that all men are created equal”).

  But step back and consider the following: Are markets really supposed to be democratic, and does having better information than the next guy really constitute a fraud that should send someone to jail for almost as long as someone who robs a bank?

  In the course of writing Circle of Friends it was not difficult to find at least a few academics (Duke law professor James Cox among them) who have concluded that it doesn’t constitute such a fraud, at least not to the extent that insider trading should be an obsession of federal law enforcement punishable by many years in jail. This obsession, I might add, has diverted resources from real and direct thefts, such as the Bernie Madoff Ponzi scheme, which regulators at the SEC all but ignored for years, until Madoff turned himself in in December 2008.

  Madoff’s activities cost actual investors real money—nearly $50 billion, depending on how much can be recouped by investigators. Lured by his promises of steady returns, people gave Madoff their life savings; charitable trusts handed him money to fund good causes. They were heartened by the fact that investigators at the SEC had done past inquiries into Madoff and found him to be clear—that is, until reality came calling. And in a flash all the money was gone, since Madoff stole it all right under the noses of investigators, who later conceded they were stretched too thin to conduct a thorough probe.

  As you will see in Circle of Friends, the SEC or the Justice Department never appears stretched too thin to eradicate insider trading. The question is, why? What is the real damage to individuals from David Slaine’s having that information, trading on it, and making a profit?

  Slaine never forced the person on the other side of the trade to buy or sell his stock. The person on the other side was going to buy or sell the same shares anyway, because the inside information available to Slaine and his circle of friends hadn’t been made public.

  They were in a sense “victims” of their own lousy investment decisions. The only difference is that David Slaine and his cohorts made money.

  Another question to consider: Do average investors really care? Viscerally most would say yes. Anything that gives an unfair advantage to one party over the other should be eradicated from the markets. This gut reaction has been interpreted for decades now by market regulators, and increasingly by federal prosecutors, to mean that the average investor would have less confidence in buying stocks and investing for retirement if they knew the game was rigged by well-connected players making a quick buck based on their exclusive access to market-moving information.

  But that doesn’t mean the market-confidence argument that regulators embrace holds up. Professor Cox, for one, says there’s little in the way of academic research
to suggest that insider trading—which has existed as long as there’s been a stock market—actually makes people wary of putting their money into the markets.

  “There’s little in terms of quantitative evidence to prove that investors care” about insider trading when making decisions about whether to buy stocks, Cox says. With that, Cox questions whether insider trading deserves more attention than other white-collar crimes. Higher on his list was mindless risk-taking that brought down the financial system in 2008, causing trillions of dollars in losses or the outright market manipulation where traders collude to push prices lower depending on their need, or Ponzi schemes of the Bernie Madoff variety, where people lost altogether tens of billions of dollars.

  Regulators would say they focus on these crimes as well, but the facts suggest otherwise. Not a single major financial executive faces jail time for crisis-related crimes. Bernie Madoff was caught, but only after he turned himself in and after regulators were warned of his activities. And yet the news of the day is the dramatic rise in cases of insider trading, a practice deemed by a vast and growing federal regulatory apparatus to be something on the scale of terrorism, when in reality it is not, at least when compared to other more damaging market-based frauds.

  Cox explains the difference this way: “When you look around you don’t see many bleeding bodies after insider trading takes place. You do see those bleeding bodies with Ponzi schemes and market manipulation in terms of people losing lots of money and never being able to recover that money.”

  This critical view, as I will show in Circle of Friends, isn’t widely accepted by the federal law enforcement bureaucracy (or most people in the media). People like David Chaves and his team at the FBI, not to mention the entire enforcement staff at the SEC, believe that trading on insider information is tantamount to robbing a bank because it is stolen information that is being used to help a privileged few to profit.

  And nothing good ever comes from stealing.

  Or does it? What makes markets function at their best is the free flow of information (related to what financial academics call the “Efficient Markets Theory).” One could argue that when David Slaine obtained information that was not public (and not his) and traded on it, he helped the public know something: The information is being used to price the stock. Most scholars as well as practitioners who study financial markets believe deeply that markets function best when stock prices (or the prices of bonds, commodities, derivatives, options, mortgages, currencies, interest rates, and the whole massive slew of financial instruments we have managed to cook up) reflect all the available information. So in that sense, David Slaine helped the markets run more efficiently, not less.

  Circle of Friends is not a defense of insider trading—far from it. But it is an attempt to provide some perspective on what our regulators view as the white-collar crime of the century, one that they’re now trying to convince the general public would be running rampant were it not for their heroic law enforcement efforts.

  And some of these efforts are heroic. People like Chaves and his team, as well as agent B. J. Kang, brilliantly turned witnesses like Roomy Khan to convict Rajaratnam. And maybe most of all, the enforcement agents at the Securities and Exchange Commission, led by an understated but determined investigator named Sanjay Wadhwa, are dedicated professionals who believe they are doing the right thing in setting the stage for the most successful insider trading crackdown in history.

  During numerous interviews, they’ve all provided the same defense of their actions: Ridding the markets of insider trading will send a message to the public that government will do all it can to make the markets fair. With ensured fairness comes confidence and with that increased confidence a new investor class will be born (while those who lost faith in the markets following the financial crisis will, perhaps slowly, return).

  Yet consider the following, as many academics I have interviewed for this book point out, and a few government officials involved in the crackdown concede:

  In the years where people like David Slaine traded on illegal information freely, market confidence, particularly among small investors, was at its height. Boatloads of money flowed into the stock markets from average investors, either directly through the purchase of individual stocks or indirectly as small investors plowed trillions of dollars into equity mutual funds and ETFs (exchange-traded funds, which for the purposes of this discussion function essentially as mutual funds—mechanisms that let small investors buy into much bigger baskets of stocks than they could affordably do otherwise).

  So when did confidence begin to dry out? It goes back to 2008, when the financial crisis and persistent worries about the direction of the U.S. economy hit individual investors and small business people hardest. That crisis, caused by greedy bankers who took on too much risk, coupled with weak regulations and poor government oversight, has had more to do with the erosion of investor confidence than anything David Slaine and his cohorts did or are still doing.

  The stock markets have recovered their losses from the financial crisis, and yet small investors remain fretful. They’ve been yanking money out of stock mutual funds since the 2008 crisis, a process that’s continued largely unabated even as the Federal Reserve has taken short-term interest rates down to zero, and only recently began purchasing stocks in modest amounts. The Fed’s interest rate policy was designed to create what’s known as the wealth effect. With interest rates so low, the Fed’s logic went, investors would flee low-yielding bonds for investments that offered higher returns, like stocks.

  But this wealth effect was largely a Wall Street phenomenon. It’s interesting to note that this mass migration out of stocks and into bonds, money-market funds, and gold by small investors occurred just as our government launched its crackdown on insider trading. Thus, just as the government was making the investing world safe, investors felt less safe. Small investors have remained in bond funds and gold—but not because they think insider traders are ripping them off. Rather, it’s because they believe the markets are vulnerable to a precipitous fall, whether it’s because of the burgeoning European banking and economic crisis, the unsustainable deficits that are devaluing the currency (the reason for the gold purchases), the dysfunction in Washington over economic policy (the reason for the purchases of super-safe bonds), a flash crash that sent stocks falling for no other reason than a computer malfunction, or all of the above.

  And maybe average investors simply accept the “unfairness” of insider trading as a minor obstacle in their financial lives. It is no secret among average investors that the big players, namely large institutional investors, and Wall Street trading houses have monopolized information flows illegally and legally for years. Consider the controversial Facebook initial public offering. In the weeks prior to the stock’s IPO, underwriters gave (perfectly legal) private briefings to large investors about Facebook’s dimming prospects but gave no such hand-holding to small investors who bought what turned out to be inflated shares through the retail networks of firms like Morgan Stanley. As I write this, months after the IPO, Facebook is still trading below its initial price. Those big investors who got out immediately or didn’t play at all are doing much better relative to the legions of small investors who made what in hindsight is a pretty bad bet.

  Or maybe they have a better, less idealized understanding of the markets and how they work than our regulators do. Read Friedrich Hayek, or Milton Friedman, or any of the great free-market thinkers and you will come away with one undeniable conclusion: Markets are by their very nature unfair; the smartest traders, those with the best information, are supposed to pick stocks better and make more money than anyone else.

  Now, Americans hate cheaters, and they don’t like those who have an unfair advantage, which is why when you ask most people about insider trading, they’ll usually say that the perpetrators belong in jail.

  To that end, the biggest coup of the ongoing insider-trading crackdown at least so far has been the conviction of Galleo
n Group founder Raj Rajaratnam, who was found guilty of insider trading and securities fraud and sentenced to eleven years in the same federal prison that houses Madoff and mob kingpin Carmine “the Snake” Persico. During the course of his career Rajaratnam made a lot of money trading, accumulating a net worth of nearly $2 billion. Wiretaps, government witnesses, and telephone recordings from informants with inside tips paint a wide pattern of abuse, leading to a well-deserved conviction.

  Yet even government prosecutors would concede that most of the money he made for himself and for his clients did not come from breaking the law. Largely overlooked by the media was the cost of Raj’s illegal dealings. Before his arrest in 2009 (and Galleon’s subsequent demise) the fund had accumulated around $7 billion in assets.

  To build a fund of that size, Raj and his team conducted many tens of billions of dollars’ worth of trades to produce overwhelmingly positive annual returns averaging around 25 percent since 1992 and amounting to billions of dollars in winnings for his clients. Yet the feds say he stole only some $70 million by trading on insider information. That figure, even if it is accurate (Raj lawyers claim the amount is closer to $7 million), would mean that the vast majority of his trades, billions upon billions in winnings, were perfectly legal.

  It would also mean that the government spent tens of millions of dollars to prosecute a crime that pales in comparison to many other shady practices that have cost the financial markets and American taxpayers untold billions and possibly trillions of dollars in losses. The shadiest of those practices, of course, led to the 2008 financial crisis, one of the world’s great economic tragedies.

  The financial crisis and its continued lack of identifiable culprits is key to understanding why insider trading is all the rage these days with the federal law enforcement bureaucracy, and why men who run hedge funds, like Raj Rajaratnam and Steve Cohen, have become more recognizable household names than those of our banking titans. Of course, bubbles like the one that caused the risk-taking that led to the 2008 collapse are often more about irrational exuberance than the more rational act of fraud. In other words, they are difficult cases to make, and upon taking office in 2009, and with the after effect of the financial crisis causing massive unemployment, regulatory officials in the Obama administration barely explained those nuances to a skeptical and hurting American public.